Are equity markets underestimating climate risks?

IMF in Global Financial Stability Report (Apr-2020) has a chapter on equity markets underestimating climate change risks:

The projected increase in the frequency and severity of disasters due to climate change is a potential threat to financial stability. Equity markets are a key segment of the global financial system, provide a data-rich environment, and are sensitive to long-term risks, making them fertile ground for investigating how projected future physical risk affects financial markets and institutions.

Looking back over the past 50 years shows a generally modest impact of large disasters on equity markets, bank stocks, and non–life insurance stocks, although country characteristics matter. Higher insurance penetration and greater sovereign financial strength have helped dampen the adverse effects of large disasters on equity markets and financial institutions.

While projections of climatic variables and their economic impact are subject to a high degree of uncertainty, aggregate equity valuations as of 2019 do not appear to reflect the predicted changes in physical risk under various climate change scenarios.

This suggests that equity investors may not be paying sufficient attention to climate change risks. Beyond policy measures to mitigate and adapt to climate change, actions to enhance insurance penetration and strengthen sovereign financial health will be instrumental in reducing the adverse effects of climatic disasters on financial stability. Moreover, better measurement and disclosure of exposures to climatic disasters are needed to facilitate the pricing of climate-change-related physical risks.

IMF has a Blog post on the chapter:

The damage from the 2011 floods in Thailand amounted to around 10 percent of Thailand’s GDP, not even considering all the indirect costs through a loss in economic activity in the country and abroad. By some estimates, the total costs of the 2018 wildfires in California were up to $350 billion, or 1.7 percent of U.S. GDP. Every year, climatic disasters cause human suffering as well as large economic and ecological damage. Over the past decade, direct damages of such disasters are estimated to add up to around US$ 1.3 trillion (or around 0.2% of world GDP) on average, per year.

As scientists warn that global warming will increase the frequency and severity of such extreme weather events, the IMF’s latest Global Financial Stability Report examines the impact of climate change physical risk (loss of life and property as well as disruptions to economic activity) on financial stability, and finds that equity investors might not be pricing these risks adequately. The COVID-19 pandemic has shown how fast and extensive disruption of economic activity can be (even for well-known types of risks), underscoring the importance of preparedness and adequate risk assessment.

From one crisis to another…

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